A brief intro about hedges

hedge is an investment to reduce the risk of adverse price movements in an asset.

Let me outline some common hedges below:

  • Cash hedge

By far one of the most common strategies. Here we keep a certain allocation of assets as cash. There are several methods to determine the percentage to keep such as constant or dynamic. For an introduction to some of the assets allocation strategy, you can refer here. The hedging cost here is at no cost but you would see a drop in net assets at a crash or correction. The excess cash will be the firepower to buy undervalued assets.

  • Buying of put options/Collar

This comes at a cost. But your portfolio can be protected. The downside is when the market is moving sideways, you will suffer a loss. Alternatively, you can set up a collar trade which is selling a call to buy a put option. The downside for this is your gains are limited when the market is very bullish. For more on it, you can refer to here.

or here

In regards to which counter or ticker to set up, you can consider using either your stock holdings or ETFs. For stock holdings that are not optionable, ETF is one of the easiest choices. Personally, for US, I prefer using QQQ or SPY. For SG stocks, EWS, since SGX stocks are not optionable.

  • Back Ratio

Another popular option strategies for a hedge is back ratio. Here we sell 2 puts and buy 1 put at a higher strike price. The premium collected from the 2 short puts are used to offset the cost the put. The cost is usually zero. However, the hedge is ineffective if the market crash badly.

For example, you sell 2 QQQ puts at strike 120 to buy a put at strike 130.

Currently, QQQ could be trading at 140. You will have the maximum profit if it drops to 120. If it drops to 110, you break even. Anything more than that, you will be losing money.

  • Short ETF

There are some inverse ETFs that rises as the market goes down. Timing is important and there are some transaction costs and it’s not fully covered. There are also double or ultra short ETFs that double or more when the market goes down. In a bull market, all your short ETF will suffer in value. Do note that many of the ETFs have decay factor due to the cost of contango.

  • Volatility play

In a crash, the volatility is high. One possible play would be having a position in VIX related ETFs to hedge against it. Some common instruments are VXX, VIXY, SVXY. You can use multiple option strategies on these instruments.

  • Long/Short Strategy

This is the most common hedge fund strategy. It involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value. The long/short pair are usually highly correlated and in the same industry. If implemented well, it offers nice risk-adjusted returns. An alternative, you can also buy a long call/put option pair of two related equities.

Key Metrics to check for online companies

  1. Monthly Active Users
    • That will be the very thing I would look at especially for online games, apps and social networking services. It is calculated by the number of unique users for a thirty day period.
    • An increasing number is a must. A drop for a long period is a warning
  2. With the current trend of going mobile, check on mobile revenue growth rate. It should be accelerating or constant.
  3. Average acquisition cost (if any) under control and declining
  4. Customer Lifetime value (depending on the online business)
  5. Average order value (depending on the online business)
  6. Retention rate (depending on the online business)
  7. Improving Margins (across all companies)
  8. Total addressable market and room for revenue growth

What makes a great business?

Characteristics Checks & Tools
Durable Competitive advantage Check Economic Moat at Morningstar, Vuru.co, industry specific rankings
Thick Profit Margins Check Gross and Net Profit Margins against competitors at Gurufocus
Low Capital Expenditures Read financial statements, check Morningstar
Integrity Check Annual Reports, Statements, Conference call, attend AGM
Look after the long term interests of shareholders
Capable Management Glassdoor, LinkedIn Reviews, Past Track Records
Great Culture Glassdoor, LinkedIn, talk to existing employees
Growing Business (Scalability) Check Total Addressable Market,
Healthy Debt Check Quick Ratio, Debt/Equity, Current Ratio at Morningstar or financial reports

What works on Wall Street

Extracted from the book

  • Stocks with the worst price momentum are horrible long-term performers
  • Single value factors have vastly better returns and battling averages than pure growth factors. The one exception to this is price momentum and should always be used in connection with a value constraint.
  • Using several value factors offers much better and consistent returns than a single factor.
  • Accounting variables such as accruals to price, asset turnover, external financing, and percentage change in debt offer key insights into which stocks have higher quality earnings. Using Several accounting variables – total accruals to total assets, the percentage change in operating assets, total accruals to average assets, and depreciation expense to capital expense – improve the quality of stocks and the return.
  • Consumer staples and utilities offer investor excellent returns at low levels of risk by focusing on value factors and shareholder yield
  • buying wall street’s current darlings with the richest valuation is one of the worst things you can do.
  • A simple strategy that buys the 25 best-performing stocks based on six-month price momentum from the stocks scoring in the upper 10 percent of value composites earn more than 20 percent per year since 1963

A tough lesson – Triyards

And so, I booked my biggest loss in SGX and sold off Triyards.

And what happened? What was my investment thesis and what went wrong?

I entered in early 2016 based on low P/B hoping for a turnaround and based on analysts report. And when it dropped further, I entered twice. My rationale behind it was the shipping industry had shown signs of picking up. There are now more ship owners asking to build new vessels. And the industry looks like it might turn around in late 2017/2018.

And I was wrong.

So what was wrong?

  • I failed to analyse their economic moat. In their latest earnings release statement (Jul 17),  their margins were hurt. They did not have a competitive advantage and faced with strong competition.
  • I had loss aversion bias and averaged down in hope of recovery. That’s a bad strategy when there’s no near term turnaround in sight.
  • The low P/B strategy did not work out. There was an impairment charge to the assets and that was one of my primary reasons for selling it out. There’s a possibility that some companies might buy over Triyards but I would not want to place too high hopes for that when the industry is still in consolidating phase and there’s no significant growth of orders in the industry. Another reason that I sold out was a rise in accounts receivables with a reduction in operating cash.

 

Lessons learnt:

  • Watch loss aversion bias!!
  • Economic moat matters
  • Macroeconomic turnaround takes time